From the July 1996 issue of Entrepreneur

The checkered history of the Research and Experimental Tax Credit (more commonly known as the R&D Credit, for research and development) has a certain "now you see it, now you don't" quality. In any given year, it's been difficult to know whether the credit is even allowed, and exactly which expenditures qualify have always been hazy as well.

Yet this tax-reduction tool offers potentially powerful savings on the kinds of cost-reduction investments so many businesses are making today. In fact, according to Glenn Mackles, a principal in the national tax department of Deloitte & Touche LLP's Washington, DC, office, "Savings of $20 million or more by large firms are now causing medium-sized and smaller companies to take a closer look at the R&D credit."

Another reason for the new-found interest in the R&D tax credit: A recent U.S. Commerce Department pronouncement on the issue spelled out more clearly than ever before what qualifies as research and development. The upshot is a surprisingly more liberal interpretation than expected, says Mackles.

One of the biggest changes, in Mackles' view, is that it's not just so-called "research companies" or companies "in the R&D phase" that qualify anymore. A large portion of the significant investments made in process engineering by many firms in recent years can probably be subtracted right from their tax bills. And while "process engineering" may sound far too high-tech for you, all it really means is figuring out how to make something better or how to deliver a service more efficiently. If you spent time and money doing this, a portion of those expenses qualifies for a tax credit, according to Mackles.

Remember, too, that unlike a deduction, which simply reduces taxable income, a credit is a dollar-for-dollar reduction of your tax bill. The credit can even be claimed for years past, Mackles says, albeit under guidelines "only an accountant could love."

On Again, Off Again

It's not difficult to understand why the R&D tax credit has often been ignored by small business. For one thing, it has been killed off and reborn more times than Frankenstein on the big screen-six times since 1981. Every couple of years Congress allows it to expire, then revives it-for two to three years at a time-typically with credits approved retroactively for the hiatus.

"[The credit] has always been confusing and tough to obtain," says Carolyn Turnbull, associate partner with accounting firm Postlethwaite & Netterville in Baton Rouge, Louisiana, and a member of the Shareholders and Corporations Committee of the American Institute of Certified Public Accountants. "Even when it was renewed or extended, few people knew it was retroactive."

When the IRS last revived the R&D tax credit two years ago, few people bothered to take note. "Who reads IRS regulations?" says Mackles.

Even now, the R&D credit is on hiatus; it expired June 30, 1995. But don't let that stop you from taking unrealized R&D tax credits from past years or from keeping proper records while you await yet another miraculous revival. Already, bills have been introduced to bring the credit back.

"There's a good deal more clarity now about what qualifies, and anybody who takes a second look will find a great deal of benefit," Mackles says. "Because of the cost-cutting moves forced on companies right now, lots of money is being spent on finding cheaper, smarter, faster ways to make existing products or deliver services."

While a simple definition of precisely what expenses qualify for the R&D credit remains somewhat elusive, Mackles says, "About 95 percent of what qualifies are wages. Eligible salaries apply toward the credit on a prorated basis, and once 80 percent of an employee's time is devoted to R&D activities, you can deduct 100 percent of his or her salary." Although it's harder to do, you can also make a case that supplies used in the effort qualify as expenses; you can't, however, consider rent or other fixed costs qualified expenses. Explains Mackles, "Bricks and mortar don't count, but supplies that get used up do."

Brace Yourself

Below, Mackles explains how to calculate your R&D credit. Don't try this at home without professional help. Because the credit expired June 30, 1995, it is available on a prorated basis for the first six months of that year. To make the math easier, we'll base our examples on 1994.

1. First, calculate average annual gross receipts for 1984-88. (For those not in business then, see step 3). Yes, it's a long time ago, and, yes, many of your accountants and employees from that time probably aren't around anymore, so getting accurate records won't be easy. But if it can save you a lot of money, it's worth doing.

2. Now figure out average annual R&D expenditures for the same five-year period.

3. Calculate a ratio of the two by dividing the average R&D spending by average gross receipts. Now you have a percentage. (If your company was formed after the base period, use 3 percent as a standard percentage.)

4. Figure the credit allowed for 1994. Take your average annual gross receipts from the previous four-year period (in this case, 1990-93), and multiply that by the percentage determined in steps 1 to 3 to get a dollar amount. The full credit for 1995 equals 20 percent of every eligible R&D expenditure above that amount.

If your average annual gross receipts for 1990-93 were $3 million, and your ratio from step 3 was 2 percent, then 2 percent of $3 million is $60,000. That means 20 percent of whatever you spent on R&D above $60,000 can be subtracted directly from your tax bill as a credit.

Technically, you can now claim credits for 1993, 1994 and the first half of 1995. For the many corporations planning to file 1995 returns in September under an extension, 1992 remains open to claims as well.

The point of all this, from the government's side, is to encourage ongoing increases in R&D spending. That's why, as the math shows, if you want to qualify for credits year in and year out, actual dollars spent on R&D must continually rise. Remember, this is an incremental tax credit-it applies only to the 20 percent of R&D spending above a base amount. Of course, if you are filing under the Alternative Minimum Tax schedule, R&D credits would have to be carried forward.

Helping Hand

Mackles says firms usually recover three to eight times what it costs to claim the R&D credit. Typically, an accountant conducts a quick appraisal to gauge the likelihood of meaningful savings before plunging in too deep.

Finally, a cautionary note: Remember that accountants' opinions and styles vary. Turnbull, for example, has strong reservations about how far R&D credits can be taken given the IRS' current language, especially when it comes to software and service companies. Still, she agrees the credits deserve attention.

But while Mackles agrees that much of the language affecting R&D tax credits remains subject to interpretation, he says the big six accounting firms, at least, are moving ahead quickly on the issue. Already, dozens of clients at his firm have claimed this credit, and the activity is filtering down to smaller companies.

Regardless of where you or your accountant fall on the risk-reward continuum of claiming credits and deductions, one time-honored dictum still applies that even Turnbull and Mackles can agree on: Keep the best possible records you can. If you want to take advantage of the R&D credit, you're going to need them.